Transcription of Problems Relating to Capital Structure and Leverage 1 ...
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Problems Relating to Capital Structure and Leverage 1 ...
Problems Relating to Capital Structure and Leverage 1. EBIT and Leverage Money Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes [EBIT] are projected to be $14,000 if economic conditions are normal. If there is a strong expansion in the economy, then EBIT will be 30% higher. If there is a recession, then EBIT will be 60% lower. Money is considering a $60,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem. a. Calculate earnings per share [EPS] under each of the three economic scenarios before any debt is issued. Also calculate the % changes in EPS when the economy expands or enters a recession. If you ignore taxes in this problem and there is no debt outstanding: Under Normal Economic Conditions EPS = EBIT/shares outstanding = $14,000/2,500 = $ Under Expansionary Times: EPS = [EBIT x ]/shares outstanding = $14,000( )/2,500 $18,200/2,500 = $ Under a Recession: EPS = [EBIT x ( )]/shares outstanding =$14,000(.)
c. What would the cost of equity be if the debt-to-equity ratio were 2 instead of 1.5 {i.e., more debt relative to equity higher leverage}? What if it were 1.0 instead of 1.5 {i.e., more debt relative to equity less leverage}? Using the information and the same methodology as in (b) with the M&M Proposition 2: With the D/E = 2 k e = k ul + [k
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